Traders Expecting A Big Volatility Surge In The Short Term

From Dana Lyons: Despite the mild selloff, 1-month volatility expectations are at an extreme relative to other durations.

In Wednesday’s Part 1 of our “Vexing VIX” mini-series, we noted that the instrument has historically been a nemesis to us. As we stated, we’ve just never had much luck figuring out how to use the VIX to help make us money. That wasn’t totally accurate, however. When considering the term structure of the VIX, we have actually found it quite useful on many occasions. Again, the term structure refers to the varying durations of volatility expectations. For example, the VIX pertains just to 1-month volatility expectations in the S&P 500 while the VXV refers to 3-month volatility expectations. When comparing the two, the result can be a helpful measure of investor sentiment.

Generally, when the stock market weakens, near-term volatility expectations rise faster than those in the longer-term. And specifically, when the 1-month VIX rises above the 3-month VXV, i.e., the VIX/VXV ratio over 1.00, it has often been a signal that sufficient fear has been built up to allow for a market bottom. This is the case presently. However, much like yesterday’s post regarding the elevated VIX readings, the circumstances surrounding the current VIX/VXV readings are unusual by historical standards.

As noted, it typically takes a significant level of selling pressure in the stock market to generate enough fear to drive the VIX/VXV ratio to 1.00 or higher. In our present case, however, the selling has been relatively mild. As of April 12, for example, the S&P 500 closed just 2.13% away from its 52-week high. Yet, the VIX/VXV ratio closed at 1.03. That marked the 3rd closest of any days in which the VIX/VXV rose above 1.00 since the inception of the VXV in 2007.

And it marked just the 22nd time that the S&P 500 was within 4% of its 52-week high (as the chart indicates, stocks have had a tendency to rally in the near to intermediate-term following prior similar readings).

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Now, if that weren’t enough vexing behavior, the very short-term volatility expectations are not confirming the 1-month readings. The VXST tracks the 9-day volatility expectations for the S&P 500. During market weakness, the VXST tends to rise faster than the VIX, just as the VIX rises faster than the VXV. That is not the case in our present circumstances.

The VXST/VIX (9-day/1-month) ratio typically follows a similar directional path as the VIX/VXV (1-month/3-month) ratio. Presently, however, it is diverging widely. In fact, as of April 12, the VXST/VIX ratio was near a record low, at 0.69, a level only surpassed shortly after the election last November. And when comparing that reading to the historically high VIX/VXV ratio (1.03), we see a record-smashing divergence, at nearly 50% above the VXST/VIX.

 

 

The iPath S&P 500 VIX Short Term Futures TM ETN (NYSE:VXX) closed at $18.26 on Thursday, up $0.34 (+1.90%). Year-to-date, VXX has declined -28.42%, versus a 4.02% rise in the benchmark S&P 500 index during the same period.

VXX currently has an ETF Daily News SMART Grade of D (Sell), and is ranked #2 of 11 ETFs in the Volatility ETFs category.


So what does this all mean? You can check out our “deep dive” look into this phenomenon at The Lyons Share, including forward returns in the S&P 500 following these events.

Check out our new “all-access” site, The Lyons Share, where members get our full research reports – as well as our complete macro market analysis EVERY DAY. If you find the original research we share here helpful and enjoyable, we think you’ll get a ton of value from The Lyons Share.

Disclaimer: JLFMI’s actual investment decisions are based on our proprietary models. The conclusions based on the study in this letter may or may not be consistent with JLFMI’s actual investment posture at any given time. Additionally, the commentary provided here is for informational purposes only and should not be taken as a recommendation to invest in any specific securities or according to any specific methodologies. Proper due diligence should be performed before investing in any investment vehicle. There is a risk of loss involved in all investments.

This article is brought to you courtesy of Dana Lyons, JLFMI and My401kPro.

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